The Art Of Valuation Jujitsu (Part 5): Express Scripts

| About: Express Scripts, (ESRX)

Originally published on November 16, 2014

>> Read Parts 1, 2, 3

As we saw in Part 4 of this series, there are four inputs to an absolute value model: cash flow from existing assets, the expected growth in those assets over the explicit forecast period, the terminal value at the end of the forecast period, and the cost of financing the assets.

When forecasting future cash flows, there are a few key drivers that must be scrutinized. These include revenue growth, which is typically estimated by taking the total market for a product or service and the company’s expected share of that market over the forecast period. You must also consider how the operating margin (OM) is going to trend over time. To do so, look at the margins for the industry. Profit margins tend to converge to the industry average over time. Revenue is then multiplied by the operating margin to arrive at earnings before interest and taxes (EBIT).

Provided below is a free cash flow forecast for Express Scripts (NASDAQ:ESRX) that I compiled in September 2013. As you can see, it includes all the components we discussed in Part 4. In this case, the explicit forecast period is 2013-2019 with FCF growing from $5,090 to $7,825 million. The terminal value of $83,409 million was calculated using my 2019 FCF estimate of $7,825 million, expected terminal growth in FCF of -0.5%, and cost of capital of 8.8% (calculation provided below).


2013E 2014E 2015E 2016E 2017E 2018E 2019E
EBIT 6,392 7,415 7,940 8,397 8,957 9,034 9,534
Minus: taxes (1,471) (1,581) (1,633) (1,727) (1,842) (1,858) (1,961)
Plus: depreciation & amortization 402 408 411 409 405 401 405
Minus: change in working capital 93 53 21 (9) (18) (20) 20
Minus: deferred taxes (150) (150) (150) (150) (100) (50) 0
Minus: capital expenditures (175) (194) (206) (207) (174) (172) (174)
Unlevered free cash flow 5,090 5,951 6,383 6,713 7,228 7,334 7,825
Free cash flow growth 1.9% 16.9% 7.3% 5.2% 7.7% 1.5% 6.7%
Discount period months (8) 4 16 28 40 52 64
Discount period years (0.7) 0.3 1.3 2.3 3.3 4.3 5.3
Discount factor 1.060 0.974 0.895 0.822 0.756 0.694 0.638
Present value of annual cash flows 5,396 5,796 5,712 5,520 5,461 5,092 4,991
Terminal value 83,409

Next, the FCF estimates over the explicit forecast period (2013-19) and the terminal value were discounted back to the present at the company’s cost of capital of 8.8% (assumed). The sum of the present value of future cash flows was $91,173 million. We refer to this as the firm value. Since we are trying to estimate the equity value (not the enterprise value of the firm), we need to deduct net debt from enterprise value. In this case, ESRX had net debt of $13,925 million. Netting the two figures, the estimated equity value per share was $94.65. When compared to the current price of $62, my intrinsic value estimate implied 52% upside.

Present value of cash flows 37,969
Plus: Present value of terminal value 53,204
Enterprise value 91,173
Minus: net debt (13,925)
Equity value 77,248
Equity value per diluted share $94.65
Current share price 62.05
Upside/(downside) potential +52.5%
Valuation assumptions
Residual growth rate -0.5%
Shares – diluted 816
Tax rate 20.6%
WACC calculation
Cost of equity (CAPM) 10.8%
Beta 1.09
Equity risk premium 8.0%
Risk free rate 2.8%
Cost of debt 2.4%
Tax-adjusted cost of debt 1.9%
% equity 77.9%
% debt 22.1%
WACC 8.8%

The valuation model will include your assumptions, which I have recapped above. Two key assumptions are the company’s cost of capital and the terminal growth rate. The cost of capital in a free cash flow to the firm model is the company’s weighted average cost of capital or WACC. As noted in Part 4 of this series, it is calculated as the weighted average of debt and equity capital used to finance the company’s assets. The cost of capital will change over time with changes in interest rates, tax rates, and the volatility of the company’s stock. In this case, the cost of capital was ~9%.

The terminal growth rate used in a DCF analysis typically ranges from -2% to +5%. In this case, I have assumed that free cash flow will decline by -0.5% annually beginning in 2020. The terminal growth rate conservatively assumes that sales growth continues to be pressured and that the company’s opportunities for margin improvement dry up post 2019.

When considering the terminal growth rate for a company, I find it instructive to ask: What does the current stock price imply about the company’s future growth rate? To answer that question, we use the cash flows we estimated above, along with the current stock price, to back into the implied terminal growth rate. In this case, the current price was implying a terminal growth rate of -7%! This seemed too draconian for a company that is expected to grow at a midpoint of +15% for the foreseeable future based on management’s estimates.

Reverse DCF
Present value of cash flows 37,969
Present value of terminal vlue 29,315
Implied terminal growth rate -7.0%
Enterprise value 67,284
Minus: net debt (13,925)
Equity value 53,359
Equity value per diluted share 65
Current share price 62

Like the analysis above, the implied growth rate suggested the company was undervalued and provided me with confidence to purchase the stock.

Disclosure: This post is for informational and educational purposes only and shall not be construed to constitute investment advice. Nothing contained herein shall constitute a solicitation, recommendation, or endorsement to buy or sell Express Scripts stock or any other security. While the author does not hold a position of employment, directorship, or consultancy with the subject company, he and/or others he advises may hold a material investment in the subject company. No one should rely on the information contained in this presentation to make any investment decision. Before investing in Express Scripts stock or any other security, seek the advice of a qualified investment professional.

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